Financial Statements Quality Questionnaire

General Accounting Principles

Statement	Yes	No
Financial reports conform to GAAP
GAAP varies by jurisdiction, such as IFRS or US GAAP
Useful financial information must be relevant and faithfully represented
Relevance includes materiality, meaning information that affects decision-making
Faithful representation means the information is complete, neutral, and free from error

Revenue Quality

Statement	Yes	No
Is your revenue highly predictable (e.g., 90% or more clients return year over year)?
Does your business generate high profitability (e.g., gross margins over 70%)?
Do you have revenue diversity (no single client makes up more than 15% of revenue)?
Growth Potential (Revenue and net income are growing)?

Financial Report Warning Signs

Statement	Yes	No
Desirable characteristics like timeliness and comparability require trade-offs
Managers can use accounting choices to manipulate reported performance
Aggressive accounting recognizes revenue prematurely or defers expenses
Aggressive accounting recognizes revenue prematurely or defers expenses22

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Financial institutions’ systemic importance leads to stringent regulation of their activities. Systemic risk refers to the possibility of disruption in a part of the financial system that could spread to other areas, ultimately affecting the broader economy. The Basel Committee, a permanent body of the Bank for International Settlements, consists of representatives from central banks and bank supervisors worldwide. Its regulatory framework for banks sets minimum requirements for capital, liquidity, and stable funding. Other global organizations that focus on financial stability include the Financial Stability Board, the International Association of Insurance Supervisors, the International Association of Deposit Insurers, and the International Organization of Securities Commissions.

A key difference between financial institutions and other businesses, such as manufacturing or retail, is that their productive assets are primarily financial, like loans and securities. This creates direct exposure to various risks, including credit, liquidity, market, and interest rate risks. Typically, the values of these assets are close to fair market value. A common framework for evaluating banks is CAMELS, which assesses Capital adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity to market risk.

• Capital adequacy measures the proportion of a bank’s assets funded by capital, indicating its ability to absorb potential losses.
• Asset quality reflects the quality of a bank’s credit and diversification, along with the effectiveness of risk management.
• Management assesses the bank’s ability to pursue profitable opportunities while managing risk.
• Earnings evaluates the bank’s return on capital relative to the cost of capital and includes earnings quality.
• Liquidity examines the bank’s liquid assets relative to its near-term cash flow needs, with Basel III also focusing on the stability of funding.
• Sensitivity to market risk measures how changes in factors like interest rates or exchange rates could impact earnings and capital.

Beyond CAMELS, analysts should consider factors such as government support, the institution’s mission, corporate culture, off-balance-sheet items, segment information, currency exposure, and risk disclosures.

Insurance companies, classified as property and casualty (P&C) or life and health (L&H), earn income from premiums and investment returns on the float (premium income not yet paid as benefits). P&C insurers typically deal with short-term policies, where claims costs are known within a year, while L&H insurers have longer-term policies with more predictable claims. Key areas of analysis for both include business profile, earnings, investment performance, liquidity, and capitalization. For P&C insurers, profitability analysis often includes reviewing loss reserves and the combined ratio.